What’s Effective Interest Rate & Annual Interest Rate?
Finance, Lifestyle,
When you plan to get a loan, you may think that you will follow only one interest rate. But that’s not the case, to be honest.
All the banks in Singapore advertise two different interest rates for personal loans; the effective interest rate and the annual interest rate.
But what’s effective interest rate and annual interest rate, and what are the differences? Where can you find the best personal loan? And which one plays the most crucial role when taking up a loan?
With our years of experience, let BST Credit explain them today!
What Is The Effective Interest Rate (EIR)?
The effective interest rate represents the actual economic cost of taking a loan. And if you are new at this, you need some time to understand this whole thing.
When it comes to EIR, most banks don’t explain the process in detail. For this reason, many borrowers do not know or don’t have much knowledge about it, which can lead them to a disaster.
The effective interest rate is calculated, including the fees applied to the original principal. Moreover, it estimates the compounding periods of a payment plan.
And thanks to this EIR, you will learn that if the frequency of payment is higher, the loan will become more costly. And if you pay bigger installments for the same amount of borrowed money, the loan will be less expensive.
What Is The Annual Interest Rate?
The Annual Interest rate or flat rate is a simple concept used by banks to quote the interest rate of your loan. The initial amount calculates this rate, and it doesn’t consider the compounding period at all!
Suppose you have taken S$20,000 from the bank and have planned to repay it for two years. And the bank said the annual interest rate would be 10% per annum. Well, when you have paid installments for a year, you are halfway done paying the principal amount, and now you owe around S$10,000 only.
But you still have to keep paying a 10% interest rate for S$10,000. It means that you are paying a higher interest rate for a lesser amount. Hence, the loan costs you more in 2 years. If you paid bigger installments and repaid the full payment in a year, you wouldn’t have to pay this extra money!
Furthermore, the annual interest rate doesn’t tell you about the processing fees, which will be deducted from your actual loan amount. So if you have applied for S$20,000, you won’t get the total amount. You will receive money that is left after deducting the fees.
This way, you are not getting S$20,000 in whole but still have to pay the interest rate that has been charged for this amount. Therefore, you should check the EIR instead of the annual interest rate when considering an interest rate while taking a loan.
What Is The Effect Of Repayment Schedule In EIR?
The repayment schedule plays a vital role in determining the ER. To give you a clear idea, let’s draw a picture.
Imagine that you have taken up a loan of S$4000, and you agreed to pay a 5% interest rate per annum. Now, let’s see how the repayment schedule will affect the effective interest rate.
Number of Installments | Occurrence of Installments | Quantity of Installment | Effective Interest Rate |
1 | Once a Year | S$4200 | 5% |
4 | Every 3 months | S$1050 | 8.16% |
6 | Every 2 months | S$700 | 8.78% |
12 | Every month | S$350 | 9.49% |
You can see that all the installments you are paying are for the same loan amount. So, the question is, why the effective rates are different?
The thing is, the sooner you try to pay off the loan, the less will be available to use. You can consider it as the value of liquidity.
How Can We Calculate The Effective Interest Rate?
To figure out the effective interest rate, you have to do some math. So yes, this part can be a bit tricky for you. But you should take a look at this one for a better experience.
Let us give you the Effective Interest Formula to learn how to calculate it correctly.
The Formula of Effective Interest Rate (EIR): 1 + (Flat rate/ number of compounding periods)) ^ (number of compounding periods) – 1
Now, let’s break down the formula for a better understanding.
In bank loans, the compound period refers to a month. And you may think that the flat rate is the advertised rate, but it is not. While calculating EIR, you must consider the internal rate of return on your actual loan balance as the flat rate.
For this reason, you should carefully calculate the EIR before committing to any bank loans. As different institutes offer different interest rates depending on your repayment period. So, if you know how to calculate the EIR correctly, you can compare multiple loans to see which one offers you the best experience.
Can I Use Any Online Calculator For Evaluating The EIR?
Suppose you are not good at math or the formula is too difficult to understand. In that case, you can surely use an online EIR Calculator. This way, you don’t have to make any guesswork, and you will be assured about the proper interest rate.
To evaluate your EIR, you need to insert the details below in the calculator.
- The amount of your loan
- The frequency of your installments
- Numbers of your installments
- The amount you want to pay in each installment
However, you can only put up to 12 installments in these EIR calculators. Hence, if you want to go for a 24-month installment, you have to do the math using the formula given above manually.
To calculate loan interest rates, use loan calculators like these.
So, Is It Wise to Go For The Lowest EIR?
Yes, when it comes to choosing your loan, go for the one offering the lowest EIR. However, while borrowing money with the lowest EIR, you need to consider some factors for a breezy experience. Let’s talk about that now.
Let’s tell you what you need to think of while taking up a loan on the lowest EIR.
How Much Interest You’re Paying In Total?
If you generally look at your loan, the lowest tenure means paying less interest rate. But that’s not the case here. Take a look at the table below to understand what happens in a longer and shorter tenure period.
Suppose Tina and Amy took a S$5000 loan, where Tina agreed for 36-month and Amy agreed to pay the loan in 60 months. And here’s what is going to happen.
Tina | Amy | |
Loan Amount | S$5000 | S$5000 |
Number of Installments | 36 | 60 |
Amount of Each Installment | S$159.72 | S$107.17 |
EIR | S$9.72 | S$9.55 |
Total Payable Interest | S$749.92 | S$1,250 |
Total Amount Payable | S$5,749.92 | S$6,250.80 |
Well, you can see that though Amy paid the lowest EIR, she spent almost S$500 more than Tina. Therefore, if you plan to take loans even on the lowest EIR, you should select the lowest tenure period to save some money!
Can You Afford The Monthly Installments?
It will be better to choose the lowest tenure period for less EIR. But shorter repayment period means that you need to pay bulkier installments. So the question is can you afford that?
If you are not capable of higher installment amounts, you shouldn’t go for the lowest tenure period. When you do so, you will feel frustrated while paying your installments and won’t be able to bear other expenses. Hence, while choosing the repayment period, you need to pick the most reasonable one.
So, if you feel okay with these two factors, you can go for the lowest EIR without any hesitation.
What Charges Will Be Applied While Taking Personal Loan Beside The Interest Rate?
Interest rates are typical in every personal loan; that’s something inevitable. On top of that, you will be charged with some common fees such as:
- Annual Fees
- Late Payment Fees
- Change in Tenure Period
Annual Fees
Some banks will charge you annual fees if you keep repaying your loan amount. Thus, if you have a 2-year tenure period, you will have to pay two annual fees over the years.
Late Payment Fees
You will be penalized when you fail to repay your monthly installments in time. Almost every bank charges this fee, so you should pay money on time to avoid these fees.
Change in Tenure Period
Suppose you have agreed to 2-year tenure but need to increase that as you cannot afford the monthly installments. The bank may agree to do that in exchange for some fees. But this facility isn’t offered by most institutes, so don’t keep high hopes!
The amount of fees depends on the bank you’re choosing. Therefore, while borrowing money, make sure you know about every fee charged upon you throughout the tenure period.
BST Credit is a financial institution in Singapore that prides itself on providing good services and transparent loan processes. We provide service of the highest standards and we are confident of finding the best loan for you.
We also offer low interest rates and flexible loan tenures.
Read what our customers say about us here.
The Bottom Line
So what’s effective interest rate and annual interest rate, you ask? Here is everything you need to know!
The annual interest is always attractive; it persuades you to borrow money without hesitation. But the effective interest rate is the real deal. Hence, if you want to have an optimal experience with your loan, evaluate the EIR thoroughly and then take the ultimate decision.
If you need help with personal loan calculations, try our loan calculator here!
You may also apply for a personal loan from the comfort of your home here.